Accounting Reference - The authoritative accounting references relate to foreign currency matters and derivative instruments and hedging activities. These rules and regulations are standard for non-governmental entities under the jurisdiction of the Financial Accounting Standards Board (FASB) in the U.S. or the International Accounting Standards Board (IASB), and apply to specific underlying foreign exchange positions, generic derivative instruments, and default and elective accounting references for hedging activities. Authoritative accounting references are presented within the accounting display of the FX Transaction Simulator and FX Derivative Speculator examples to identify the exact US GAAP accounting reference in the FASB guidance and reinforce compliance with the relevant financial reporting rules.
Best Practices – Foreign exchange best practices refer to generally-accepted, informally-standardized techniques, methods or processes used in foreign exchange risk management that have proven themselves over time to accomplish given economic and financial reporting tasks strategically.
Booking Rate - A foreign currency booking rate is the foreign exchange rate used to initially measure the foreign currency transaction in the functional currency of the recording entity. The authoritative accounting guidance generally indicates recording foreign currency transactions at the daily spot rate. In practice however, the booking convention used varies from firm to firm. As an alternative to the daily spot rate, some firms use an average spot rate for the period or a prior-month end spot rate. A foreign exchange booking rate is an important aspect of foreign exchange risk management from both a finical reporting perspective and a cash flow and working capital perspective. This is so because firms that book foreign currency transactions at an average rate will reflect the average rate functional currency value on their financial statements. However, if the same firm were to physically convert the foreign currency denominated cash, it would be done at the daily exchange rate. Therefore, there is a difference between the realized functional currency cash and the realized functional currency amount reported on the financial statements. This difference may or may not be reported in the financial statements. In contrast, a daily rate booking convention does not have these same ramifications.
Cash Flow Hedge – A foreign currency cash flow hedge is an elective accounting designation that refers to the hedge of the foreign currency risk exposure to variability in the cash flows of a recognized asset or liability or a forecasted transaction.
Collar - A foreign currency collar is a derivative comprised of a purchased out of the money option and a sold out of the money option, whereby the premium received from the sold out of the money option is used to partially or completely offset the premium paid on the purchased out of the money option to create zero or reduced cash outlay or cash inflow. When used as a hedge, a foreign currency collar provides 100% protection on the down side, the floor, and limits upside participation to a finite range, the cap. This guarantees that the purchase or sale of the underlying currency will not deviate from the range between the two option strikes. A long foreign currency collar, used as a hedge, represents the obligation to buy a quantity of a particular currency within a specific range on a pre-arranged date three days or later from the trade date. A long foreign currency collar is constructed through the purchase of an out of the money call option and the sale of an out the money put option. The purchased call option sets the floor, which is the protection level or worst case scenario, and the sold or written put option sets the cap, the best case scenario at which a firm would buy the underlying currency. A short foreign currency collar represents the obligation to sell a quantity of a particular currency within a specific range on a pre-arranged date three days or later from the trade date. A short foreign currency collar is constructed through the purchase an out of the money put option and the sale of an out of the money call option. The purchased put option sets the floor, or protection level or worst case scenario, and the sold or written call option sets the cap, or the best case scenario at which a firm would sell the underlying currency. Please also see Option. Collar Call Strike - For a long foreign currency collar, the collar call strike represents the worst-case exchange rate at which the holder may buy the underlying foreign currency. For a short foreign currency collar, the collar call strike represents the best-case exchange rate at which the holder may sell the underlying foreign currency. Collar Put Strike – For a long foreign currency collar, the collar put strike represents the best-case exchange rate at which the holder may buy the underlying foreign currency. For a short foreign currency collar, the collar put strike represents the worst-case exchange rate at which the holder may sell the underlying foreign currency. Cost/Price Determination - Cost/Price refers to the determination of the functional currency amount a company will receive or pay, at the start, interim, or end date of a predetermined transaction period, as a result of a foreign currency transaction. Please see term Foreign Currency Transactions. Counterparty - A counterparty is a financial term used to identify the parties with obligations under the contractual or non-contractual terms of an underlying or derivative foreign currency transaction. The term counterparty can refer to either party contractually or non-contractually obliged, depending on context.
Day Count - Day count refers to the day count convention, 360 or 365, used to quantify periods of time to maturity, which is used in various mathematical formulae.
Debit and Credit - Debit and credit are formal bookkeeping and accounting terms. They are fundamental concepts in accounting that represent the two sides of each individual transaction recorded in an accounting system. A debit transaction can be used to reduce a credit balance or increase a debit balance. A credit transaction can be used to decrease a debit balance or increase a credit balance. Debits and credits form the basis of the double-entry bookkeeping system. For every debit transaction there must be a corresponding credit transaction and vice versa, with the exception of net income generated from a foreign currency functional subsidiary which may be a one sided entry. Every debit and credit value is initially recorded through journal entries and from these journal entries they are transferred to ledgers and finally from these ledgers financial reports, such as an income statement and balance sheet, can then be prepared. Please also see Journal Entries.
Default Foreign Exchange Accounting - The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of an elective hedging relationship. The default accounting treatment recognizes the gain or loss on a derivative instrument currently in earnings.
Delta - The term delta refers to the periodic change in value of the functional currency price that would be received to sell a foreign currency asset or paid to transfer a foreign currency liability in an orderly transaction between foreign exchange market participants from one measurement date to the next measurement date, which may be the start, interim or end dates of the predetermined transaction period. The foreign exchange position delta is the periodic change in value of a FX position from one point in time to another given changes in the underlying exchange rate of the foreign currency pair. A FX delta can apply to an interim, end, net, or total delta of a long, short, hedged, or speculative position.
Derivative – A foreign currency derivative is a contract between two parties providing for a payoff from one party to the other determined by the price of a foreign currency exchange rate. A currency derivative is a financial contract between two parties whose value is derived from one or more underlying currencies. Derivatives can be over the counter, "OTC," or exchange traded, but the most common foreign exchange derivatives are currently over the counter forward contracts, option contracts, and option combinations such as a collar.
Direct Currency Quotation - Currencies are quoted in the foreign exchange market in one of two ways, a direct quote or an indirect quote. A direct quote, also known as an American quote, is the domestic currency per unit of the foreign currency. For example, in the U.S., the euro is quoted against the U.S. dollar in direct terms, such that the amount of domestic currency, USD, it takes to acquire one unit of the foreign currency, the euro, fluctuates. It could be as little as USD 0.9000/ EUR 1.0000 or as high as USD 1.6000/ EUR 1.0000 depending on supply and demand.
Earnings - Earnings refer to the amount of profit or loss that an entity generates and reports on the income statement during a specific period, which for example may be a month, quarter, or a year.
Economic Globalization - Economic globalization refers to the process of the world economy becoming more integrated than ever before. With the emergence of economic globalization, the international movement of goods, services, technology, and capital has expanded quickly, bringing about rapid expansion in the foreign exchange market since the 1970s.
Effective Hedge – An effective hedge means that the designated portion of the underlying FX position and the FX derivative have matching currencies, dates, and notional amounts, such that offsetting changes in fair value or cash flows are achieved, and a near symmetrical or favorable asymmetrical offset is achieved from the hedge.
Elective Foreign Exchange Accounting - The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of an elective hedging relationship. The elective accounting treatment defers periodic mark-to-market gains and losses on a derivative instrument in equity during the life of the hedge, and reclassifies the cumulative gain or loss on a derivative instrument in earnings when the hedged underlying foreign exchange position impacts earnings, aligning the timing and impact to the income statement for the hedged transaction. Elective accounting better aligns the financial reporting with the economics of the hedge by accounting for both sides of the hedged transaction in the same geographic area of the income statement at the same time.
Elective Hedge Documentation – For elective foreign exchange accounting treatment, formal contemporaneous hedge documentation must be prepared at the inception of the hedging relationship in accordance with the relevant authoritative accounting guidance. Elective hedge documentation requires specification of the hedging relationship, entity’s risk management objective, strategy for undertaking the hedge, identification of the hedging instrument, identification of the hedged item, the nature of risk being hedged, the method of assessing the hedge instrument’s effectiveness, and the ongoing and subsequent accounting treatment. Please also see term Qualifying Exposures.
End Date – End date refers to the close of the predetermined transaction period, where an underlying foreign currency position and/or foreign currency derivative is recognized, settled, or expires.
Eurocurrency Deposit Market – The Eurocurrency Deposit Market is the market for offshore deposits in U.S. dollars and other major world currencies that was developed in the 1950s and 1960s that facilitated and cultivated the process of interest rate trading. The Eurocurrency Deposit Market closely links the foreign exchange market and the money markets of the major countries and regions in the world creating a highly efficient global interest rate market and equalizing returns.
Examples - Examples refer to the proprietary risk analysis models used to represent the performance of a foreign exchange risk management strategy by reducing processed user inputs, calculation output, and generated information related to a foreign exchange risk management strategy to retain only information relevant to the strategic, economic, and accounting performance of a particular strategy. Risk analysis models highlight the critical elements of a global business enterprise’s risk management decision making process to deal with foreign exchange risk and foreign exchange market movements in discrete time in a deterministic result-oriented manner built around financial statements.
Expense - Foreign currency expenses represent an unrecognized short foreign currency position. Expenses are recorded on the income statement, and can come from many sources depending on the nature of one’s industry, and may be third party or intercompany and include cost of goods sold, operating expenses, interest expenses, and other expenses.
Exposed (Un-hedged, Un-hedged Exposure) – An exposed or un-hedged foreign exchange position refers to an underlying foreign exchange position subject to fluctuating foreign exchange rates with no associated hedge, FX derivative, or established hedging relationship.
Equity - Equity refers to a geographic section on an entity's balance sheet, showing the amount of funds contributed by stockholders and retained earnings or losses generated from the entity cumulatively.
Equity Other Comprehensive Income (OCI) – Equity Other Comprehensive Income (OCI) is a geographic section on a company’s balance sheet within equity, where foreign exchange gains and losses are recognized for certain underlying FX positions, such as a net investment in a foreign operation, and where foreign exchange gains and losses are deferred for elective foreign exchange accounting designations, such as a cash flow or net investment elective accounting designation.
Favorable (Advantageous or Acceptable) - Favorable or advantageous means the most economically valuable foreign exchange position throughout and/or at the end of the predetermined transaction period. For example, the smallest value represents the most economically valuable short foreign exchange position, the greatest value represents the most economically valuable long foreign exchange position, and positive interim deltas or changes in value represent economically valuable changes in value, all of which are considered favorable or advantageous. The opposite would be considered disadvantageous or unfavorable. For example, for a long underlying foreign exchange exposure, if an un-hedged spot position reflected the greatest ending value, an un-hedged spot transaction would represent the most advantageous economic strategy for managing a long underlying foreign exchange position, and would be considered most favorable. Conversely, the smallest ending value would indicate the least advantageous strategy for hedging a long underlying foreign exchange position in that economic environment, and would be considered unfavorable. Additionally, if a specific foreign currency was trading at the low end of the trading range over the last decade for example, the currency has depreciated in value. In turn, for a long foreign currency position, this would represent an unfavorable, unacceptable, or disadvantageous foreign exchange rate relative to the historical trading range. Conversely, for a short foreign currency position, this would represent a favorable, acceptable, or advantageous foreign exchange rate relative to the historical trading range.
Forecasted Transaction – A forecasted transaction is a foreign currency transaction that is highly probable to occur but has not yet occurred and is therefore not recognized on the financial statements. A forecasted transaction meets the definition of highly probable as defined below. Please see Highly Probable.
Forecasted Asset or Liability - Foreign currency forecasted assets and liabilities represent unrecognized long or short foreign currency positions, and come from many sources depending on the nature of one’s industry. Foreign currency forecasted assets and liabilities are recorded on the balance sheet, and could represent any of the following such as an inventory purchase (short FX to acquire asset) later expensed through cost of goods sold, an equipment purchase (short FX to acquire asset) later expensed through depreciation, a forecasted debt issuance (long FX to incur liability), a forecasted purchase of a wholly or partially owned subsidiary (short FX to acquire asset), or a forecasted purchase of an equity method investment (short FX to acquire asset) among others.
Foreign Currency - A foreign currency is a currency other than the functional currency of the entity being referred to. For example, any currency other than the US dollar could be a foreign currency to a US dollar functional company, such as the euro, Japanese yen, or British pound.
Functional Currency - An entity's functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash. An entity’s functional currency is the currency in which their financial statements are measured. For example, the US dollar could be the functional currency of a company domiciled in the United States. The functional currency of an entity is the foundation from which a company can determine their FX exposure profile and strategy for FX risk management.
Foreign Currency Accounting Risk – Foreign currency accounting risk is the risk associated with improper accounting treatment for foreign exchange transactions, which may arise when accounting procedures and rulings related to foreign exchange change, have not yet been established within an industry or organization, or are misinterpreted or misapplied.
Foreign Currency ("FX" or "Foreign Exchange") Risk - Foreign exchange risk, or currency risk, arises from the change in price of one currency against another. The volatility of fluctuating or changing foreign exchange rates has a significant impact on the profits of multinational businesses. This impact is reflected on the income statement, the balance sheet, working capital and cash flows, as well as from a purchasing power perspective.
Foreign Exchange Risk Management - FX risk management involves identifying, analyzing, and prioritizing various FX risks, and developing and implementing a coordinated and systematic plan that utilizes resources efficiently and effectively to optimize FX risk. FX risk management involves a combination of risk retention and reduction. Risk retention involves controlling the risk, and accepting the gain or loss, and risk reduction involves mitigating the risk to an acceptable level by understanding when and how to hedge using financial instruments.
Foreign Currency Risk Types - The ten most common underlying foreign exchange transactions are as follows; 1) forecasted unrecognized FX revenue, 2) forecasted unrecognized FX asset, 3) forecasted unrecognized FX expense, 4) forecasted unrecognized FX liability, 5) recognized FX receivable revalued through earnings, 6) recognized FX payable revalued through earnings, 7) long net income from a foreign currency functional subsidiary, 8) short net income from a foreign currency functional subsidiary, 9) long net investment in a foreign currency functional subsidiary revalued through equity, and 10) short net investment in a foreign currency functional subsidiary revalued through equity.
Foreign Currency Statements – Foreign currency statements are financial statements that employ as the unit of measure a functional currency that is not the reporting currency of the reporting entity. For example, a US dollar functional parent’s European subsidiary could use the euro as their functional currency and maintain financial statements measured in euros, and the US parent would have a euro denominated net investment in a foreign operation.
Foreign Currency Transactions – Foreign currency transactions are transactions whose terms are denominated in a currency other than the entity's functional currency. Foreign currency transactions arise when a reporting entity does any of the following:
A) Buys or sells in cash or on credit goods or services whose prices are denominated in foreign currency.
B) Borrows or lends funds and the amounts payable or receivable are denominated in a foreign currency.
C) Is a party to an unperformed currency derivative such as a forward contract, option contract, or option combination.
D) For other reasons, acquires or disposes of assets, or incurs or settles liabilities denominated in a foreign currency.
For example, a US dollar functional company could have a foreign currency transaction in the form of euro revenue or a euro receivable, a British pound expense or British pound payable, a forecasted acquisition denominated in Japanese yen, or debt denominated in Swiss francs.
Foreign Currency Translation – The process of expressing in the reporting currency of the reporting entity those amounts that are denominated or measured in a different currency. For example, a US dollar functional company would have to translate a foreign currency transaction such as euro revenue or a British pound expense into US dollars for reporting purposes. Similarly, a US dollar functional parent’s euro functional subsidiary’s euro denominated financial statements would need to be translated into US dollars at each reporting period for consolidation purposes.
Foreign Entity (Net Investment) - An operation (for example, subsidiary, division, branch, joint venture, and so forth) whose financial statements are both:
A) Prepared in a currency other than the reporting currency of the reporting entity
B) Combined or consolidated with or accounted for on the equity basis in the financial statements of the reporting entity.
For example, a US dollar functional parent could have a European subsidiary, whether wholly owned and consolidated for or as part of an equity method investment that uses the euro as their functional currency and is considered a net investment in a foreign operation.
Forward - A forward contract is similar to a spot transaction insofar as it represents the direct exchange of one currency for another, but differs in that settlement occurs on a pre-arranged date three business days or later from the trade date. The forward rate, or forward exchange rate, is fixed on the trade date and almost always differs from the spot rate in that it reflects the interest rate differential between the two currencies in the pair. A long foreign currency forward transaction represents the obligation to purchase one currency for another at the "all-in" forward rate on a pre-agreed date three days or later from the trade date. A short foreign currency forward is the direct sale of one currency for another at the "all in" forward rate on a pre-agreed date three days or later from the trade date.
Garman-Kohlhagen Option Pricing Model (European Options) – The Garman-Kohlhagen option pricing model is a model for pricing European foreign currency options. Options can be "European", which means exercisable only at maturity, or "American," which means exercisable on or before maturity, which are more expensive and much less common. "European" foreign currency options are used overwhelmingly in practice and comprise the majority of option trading in the over the counter "OTC" derivative market. The Garman-Kohlhagen option-pricing model is a complex equation that takes into account the following six current foreign exchange market variables:
1) Spot exchange rate
2) Interest rate on the functional currency
3) Interest rate on the foreign currency
4) Strike price of the option
5) Time to expiration
6) Volatility of the exchange rate
The Garman-Kohlhagen formula requires that FX rates, both the strike rate and current spot rate, be quoted in direct terms to reflect the units of domestic currency per unit of foreign currency. This model is supported by a principle called "Put-call parity," which says when the strike price is the same as the forward rate, known as an "at the money forward" strike, a put and a call option on the same currency with the same expiration will be equal in value.
Graphs / Charts - Graphs refer to line charts visually accessible in the economic display of the FX Transaction Simulator and FX Derivative Speculator examples. Each line chart displays 3 series of continuous data, the starting value, ending value, and payoff profile of a foreign exchange risk management strategy, over the predetermined transaction period, set against a common scale of functional currency values, which are ideal for showing fluctuations in the value of a foreign exchange position over time and the potential values that could result based on user specified inputs. A line chart distributes the three series of foreign exchange data evenly along the horizontal category axis (x-axis which contains foreign exchange rates), and distributes all value data evenly along the vertical value axis (y-axis which contains functional currency values).
Hedge (hedging relationship) – A foreign currency hedge is a transaction to protect a position or anticipated position in the foreign exchange spot market by using an opposite position in the foreign exchange derivative market. A foreign currency hedge involves taking an offsetting position in a specific currency in order to reduce the risk of unfavorable foreign exchange rate fluctuations, whereby when the underlying position incurs a loss the hedge incurs a gain, and vice versa. The objective of foreign currency hedging is to make the functional currency outcome more predictable and certain. When implementing a foreign currency hedge, various derivatives can be used to create different payoff profiles, and the accounting treatment may differ based on default or elective accounting designations.
Hedge Instrument - A FX hedge instrument is the FX derivative used in a hedging relationship.
Hedged Item – A FX hedged item is the underlying FX position in a hedging relationship. Highly Probable Transaction - A highly probable transaction is a transaction that has detrimental economic and opportunity ramifications if the transaction did not materialize, and would consider at least one of the following criteria: - The frequency and history of similar transactions -The amount of time until the forecast materializes -The amount of the foreign currency transaction -The financial and operational capacity of the counterparty to complete the transaction
Indirect Currency Quotation - Currencies are quoted in the foreign exchange market in one of two ways, a direct quote or an indirect quote. An indirect quote, or European quote, is the foreign currency per unit of domestic currency. For example, in the US, the Canadian dollar is quoted against the U.S. dollar in indirect terms, such that the amount of foreign currency, CAD, per one unit of the domestic currency, USD, fluctuates. It could be as many as CAD 1.6000 / USD 1.0000 or as little as CAD 0.9000/ USD 1.0000 depending on supply and demand.
Inputs (FX Market and Company Variables) - The inputs take the form of "assumptions" or a foreign exchange market and company specific forecast, and the user specifies the values that will apply at the beginning and end of the predetermined transaction period for foreign exchange market variables such as exchange rates, interest rates, and market volatility, as well as company specific variables such at the timing and amount of the transaction and desired hedging strategy. Correspondingly, both of these foreign exchange market variables and company specific variables are reflected in the nature of the risk analysis models. Inputs include (1) functional currency, (2) foreign currency, (3) currency quotation, (4) booking rate, (5) foreign currency notional(s) A & B, (6) day count, (7) start date, (8) start spot rate, (9) start domestic interest rate, (10) start foreign interest rate, (11) start volatility, (12) start option strike rate, (13) start collar put strike, (14) start collar call strike, (15) end date, (16) end spot rate, (17) end domestic interest rate, (18) end foreign interest rate, (19) end volatility, and (20) FX net investment liquidation.
Interest Rates – The FX interest rates refer to continuously compounded domestic and foreign risk free simple interest rates related to a currency pair. The foreign exchange market utilizes money market equivalent interest rates determined in the Eurocurrency deposit market, which is where short-term fixed-rate time deposits denominated in a currency outside the jurisdiction of the issuing central bank are exchanged.
Interest Rate Parity – Interest rate parity is a financial concept that refers the to relationship between the spot and forward currency exchange rates and the interest rates in two countries. It is used in the valuations of forward rates and option values. The forward rate, or forward exchange rate, almost always differs from the spot rate in that it reflects the interest rate differential between the two currencies in the pair. This is a function of interest rate parity, whereby the discount or premium in the forward rate, will neutralize the difference in interest rates in the Eurocurrency deposit markets between the two currencies in the pair, eliminating arbitrage opportunities for risk free profit.
International Financial Reporting Standards (IFRS) - International Financial Reporting Standards (IFRS) refer to the authoritative accounting guidance established by the International Accounting Standards Board (IASB), which is an independent, privately funded accounting standard-setter based in London, England. It is responsible for developing International Financial Reporting Standards (IFRS) and promoting the use and application of these standards. IFRS sets forth rules and guidance related to specific underlying foreign exchange positions, generic derivative instruments, and default and elective accounting rules for hedging activities among other areas of financial reporting guidance.
Interim Date – Interim date refers to one or more dates within the predetermined transaction period, where an underlying foreign currency position and/or foreign currency derivative is forecasted, recognized, entered into or settled.
ISO 4217 Currency Codes – ISO 4217 Currency Codes are the international standard describing three-letter codes to define the names of currencies established by the International Organization for Standardization (ISO). The ISO 4217 Currency Code list is the established standard in banking and business globally, and is also known publicly to a lesser extent since these codes are used for the exchange rates published in media and by financial institutions. ISO 4217 Currency Codes define the different currencies instead of ambiguous currency symbols to remove any ambiguity about the currency denomination.
Journal Entries – Accounting journal entries are used to record transactions using double entry accounting, which implies that transactions are always recorded using two sides, debit and credit. Accounting journal entries keep a record of accounting transactions in chronological order as they occur. Journal entries are recorded to a ledger, which is a record that keeps accounting transactions by accounts. All accounting transactions are recorded through journal entries that show account names, amounts, and whether those accounts are recorded in debit or credit side of accounts. Debit refers to the left-hand side and credit refers to the right-hand side of the journal entry. The sum of debit side amounts should equal to the sum of credit side amounts, with the exception of net income. A journal entry is in balance when the sum of debit side amounts equals the sum of credit side amounts.
No Definitions Listed
Long Foreign Exchange Position – A long FX position involves the inflow (receipt) of the foreign currency. For example, foreign currency revenue or a foreign currency receivable are both long FX underlying positions, and a long foreign currency forward or a vanilla call option are both long FX derivative positions, since all positions involve the inflow of the foreign currency. A long functional currency equivalent of a long FX position at a point in time within the predetermined transaction period may be a start, interim, end, net, or total long value or delta.
Mark-to-Market – FX mark-to-market refers to fair value accounting guidance where a foreign currency asset or liability is accounted for based on the current market price of the asset or liability. At each reporting period, changes in the fair value of an underlying foreign currency position or foreign currency derivative may need to be recorded directly on the financial statements in the period in which the change in value occurs, referred to as marking the foreign exchange position to market.
Maturity (Expiry) – Maturity refers to the end date of the predetermined transaction period, and may refer to the booking or settlement date of the underlying foreign currency position, or the expiration date on which the foreign currency derivative contract no longer exists.
Natural Hedge – A natural hedge involves matching offsetting cash flows from normal business operations, whether intentionally or unintentionally, which reduces the risk of undesirable exchange rate movements naturally. Identifying natural hedges is an essential first step in determining a firm’s net foreign currency exposure. For example, four types of natural foreign currency hedges are forecasted revenue naturally hedged with a forecasted expense, booked receivable naturally hedged with a booked payable, forecasted revenue naturally hedged with a booked payable, and a forecasted expense naturally hedged with a booked receivable among others.
Net Income - Foreign currency net income represents an unrecognized long or short foreign currency position, but in practice typically represents an unrecognized long foreign currency position. Translated net income is recorded on the consolidated income statement, and can exist as a result of the earnings generated at a foreign currency functional wholly owned subsidiary or equity method investee among others.
Net Investment - Foreign currency net investment represents a recognized long, asset, or short, liability, foreign currency position revalued through equity, but in practice normally represents a recognized long foreign currency position. Specifically, when assets translated at current rates exceed liabilities translated at current rates, a firm is left with a positive net equity position. A foreign currency net investment is recorded on the balance sheet, and can exist as a result of equity ownership or a liability stake in a foreign currency functional wholly owned subsidiary or equity method investee among others. Also see term Foreign Entity.
Net Investment Hedge – A foreign currency net investment hedge is an elective accounting designation that refers to the hedge of the foreign currency risk exposure associated with a net investment in a foreign operation. Notional Amount – The notional amount is the measure of the size of the underlying FX position or FX derivative stated in units of foreign currency, on which functional currency values, deltas, and payments are calculated.
Objectives – Objectives refer to the desired result the user plans to achieve, which may be economic or financial reporting related or both. For example, an economic objective may be to insure against a worst-case exchange rate for a particular currency pair by entering into a derivative to protect cash flows. Then, a financial reporting objective may be to reduce interim income statement volatility and protect earnings per share by designating the foreign currency derivative for elective accounting treatment. This is an example of two separate objectives of a desired foreign exchange risk management result the end user plans to achieve.
Operating Income – Operating income is a critical measure and line item on a company’s income statement used to calculate operating margin and commonly reflects earnings before interest and taxes (EBIT). Operating margin equals operating income divided by net sales, and is used to measure a firm’s operating profit and efficiency. Operating income measures the residual revenue left over after paying for variable costs, and is keenly observed for internal and external performance measures of a company by employees, analysts, and investors. Operating income is defined because reference is drawn to the income statement classification of various underlying foreign exchange positions, and default and elective accounting for foreign exchange derivatives. For example, a forecasted foreign currency revenue position is accounted for in gross margin and/or operating income, while changes in the value of a recognized foreign currency receivable are accounted for outside of operating income and impacts other income and expense. While net income eventually remains the same, firms often seek to control operating income strategically by accounting for both sides of a hedged transaction in the same geographic area of the income statement at the same time for its association with a company’s operating efficiency.
Option (Vanilla Option) - A foreign currency option gives the buyer the right, not the obligation, to buy or sell a quantity of a particular currency at a specific price, called the strike price, on a pre-arranged date. A call option is the right to buy a particular currency, and a put option is the right to sell a particular currency. In essence, every option is both a put and a call. For example, an option to buy EUR / sell USD is both a EUR call and USD Put when dealing in currency pairs. Unlike a forward, an option is a right, not an obligation, so it will be exercised only when it is favorable to do so. An option is comprised of two value drivers, intrinsic value, the difference between the strike rate on the contract and the then prevailing spot or forward rate in the market, and time value, which is any excess value beyond intrinsic. A purchased option begins its life as an asset in the amount of the option premium paid to the counterparty at inception, typically purely time value, and finishes at intrinsic value which is either positive or zero. Intrinsic value when positive is known as "in the money" since the strike is more favorable than the spot, and when zero is known as "at the money" since the strike is equal to the spot or "out of the money" if the strike is less favorable than the spot. A European call option gives the buyer the right, not the obligation, to buy a quantity of a particular currency at a specific strike price on a pre-arranged date three days or later from the trade date. A European put option gives the buyer the right, not the obligation, to sell a quantity of a particular currency at a specific strike price on a pre-arranged date three days or later from the trade date. A vanilla option is a normal option with no special, unusual, or exotic features. In contrast, exotic options exist such as Barrier options, American options, Digital options, and many more. Vanilla options are by far the most commonly used currency option in the currency option market.
Participate – Participate refers to foreign currency derivatives, such as an option or collar, with asymmetrical payoff profiles that provide protection against unfavorable market moves beyond the option or collar strike, while retaining the ability to realize, or participate in, some or all favorable market movements in the associated foreign currency pair.
Payable - Foreign currency payables represent a recognized short foreign currency position revalued through earnings, and come from many sources depending on the nature of one’s industry. A foreign currency payable is recorded on the balance sheet, and could represent a single payable position, multiple payables, or a net payable amount. Payable sources can be third party or intercompany and may include accounts payable from trade related expenses, notes payable from financing transactions, and other non-functional currency monetary liabilities among others.
Payoff Profile – The foreign exchange payoff profile is the potential amount of functional currency received from a foreign currency position throughout or at the end of the predetermined transaction period, which fluctuates based on hedge strategies and changes in foreign exchange rates.
Premium – Premium refers to the functional currency amount the buyer would pay the seller of the foreign currency option or collar, which reflects the option or collar’s price at any point in time throughout the predetermined transaction period.
Qualifying Exposures – Qualifying exposures refer to elective foreign exchange accounting treatment. In order to implement elective accounting treatment, the hedged item and hedge instrument must be eligible for elective accounting treatment based on the authoritative accounting guidance. In general, an unrecognized foreign currency firm commitment or forecasted transaction and a net investment in a foreign operation typically qualify for elective accounting treatment. Qualifying underlying exposures, or hedged items, are FX revenue, FX expense, long FX net investment, short FX net investment, forecasted FX asset, and forecasted FX liability positions, and qualifying derivatives, or hedge instruments, are FX forwards, FX vanilla options, and FX collars with a zero fair value or positive fair value at inception.
Qualitative FX Assessment - A qualitative FX assessment uses subjective judgment based on non-quantifiable information, such as management expertise, business and economic cycles, foreign exchange market forecasts, research and development, and understanding and interpretation of comprehensive foreign exchange market and company specific information. This type of analysis technique is different than quantitative analysis, which focuses on numbers. The qualitative assessments include two sequential question series that identify the most favorable hedge instrument based on company specific economic objectives and the most favorable accounting strategy based on company specific financial reporting objectives through a predetermined question and answer series. Both quantitative and qualitative techniques are used together to compensate for variables such as FX risk management expertise, which does not show up in quantitative analysis.
Quantitative FX Assessment - A quantitative FX assessment is a financial analysis technique that seeks to understand foreign exchange risk and risk management by using complex mathematical and statistical modeling, measurement, and research in order to simulate foreign exchange transactions mathematically. A quantitative FX assessment is used to evaluate performance and valuation of foreign exchange positions to predict real world events such as changes in foreign exchange market and company specific variables. Quantitative analysis is performed by the FX Transaction Simulator and FX Derivative Speculator examples in each risk analysis model by quantitatively ranking the four or more most common foreign exchange hedge strategies based on user selected inputs side by side, which include a spot, forward, vanilla option, and collar transaction, and quantitatively comparing the accounting debits and credits for default and elective accounting treatment side by side for qualifying exposures and strategies.
Receivable - Foreign currency receivables represent a recognized long foreign currency position revalued through earnings, and come from many sources depending on the nature of one’s industry. A foreign currency receivable is recorded on the balance sheet, and could represent a single receivable position, multiple receivables, or a net receivable amount. Receivable sources can be third party or intercompany and may include accounts receivable from trade related sales, notes receivable from financing transactions, and other non-functional currency monetary assets among others.
Recognized Foreign Currency Position – A recognized FX position, or booked FX position, means that the FX risk is expressed outside or external to the transaction in the form of FX gains and losses. Recognized FX risk exists from the time an exposure is recognized on the balance sheet through the settlement day. Recognized FX risk is a reflection of the revaluation process of non-functional currency monetary assets and liabilities, which are subject to mark to market accounting with gains and losses accounted for on the face of the company’s income statement or in the equity section of the balance sheet depending on the nature of the FX position. For example, a foreign currency receivable is a recognized FX position, and unlike an unrecognized FX position, changes in the value of the foreign currency receivable are recorded on the income statement on a current basis at each periodic reporting date.
Recommended – Recommended refers to accounting treatment best practices for default and elective accounting treatment. Recommended accounting treatment first considers the accounting treatment of the underlying foreign exchange position, and then best aligns the hedge accordingly. For example, if the gains and losses for the underlying foreign exchange position are recorded on the income statement on a current basis, default accounting treatment is recommended such that the derivative is also recorded on the income statement on a current basis to create an offset in earnings. Conversely, if the gains and losses for the underlying foreign exchange position are not recorded on the income statement on a current basis, elective accounting treatment is recommended to allow derivative gains and losses to be deferred in equity until the underlying transaction impacts earnings.
Revenue - Foreign currency revenues represent an unrecognized long foreign currency position. Revenue is recorded on the top line of the income statement, and can come from many sources depending on the nature of one’s industry and may include third party sales, intercompany sales, deferred revenues, royalty receipts, interest income, and other income sources.
Risk Analysis Model - Risk analysis models refer to data structures visually accessible through Examples such as the FX Transaction Simulator and FX Derivative Speculator that represent the performance of a foreign exchange risk management strategy by reducing processed user inputs, calculation output, and generated information related to a foreign exchange risk management strategy to retain only information relevant to the strategic, economic, and accounting performance of a particular strategy. Risk analysis models highlight the critical elements of a global business enterprise’s risk management decision making process to deal with foreign exchange risk and foreign exchange market movements in discrete time in a deterministic result-oriented manner built around financial statements.
Short Foreign Exchange Position – A short FX position involves the outflow (payment) of the foreign currency. For example, a foreign currency expense or a foreign currency payable are both short FX underlying positions, and a short foreign currency forward or a vanilla put option are both short FX derivative positions, since all positions involve the outflow of the foreign currency. A short functional currency equivalent of a short FX position at a point in time within the predetermined transaction period may be a start, interim, end, net, or total short value or delta. Speculative – A speculative foreign exchange position refers to a foreign exchange derivative entered into with no associated underlying FX position or established hedging relationship.
Spot Transaction - A FX spot transaction is the direct exchange of one currency for another at the current market price. Foreign currency spot transactions are integral to every foreign exchange transaction, meaning whether it is an underlying spot transaction or a currency derivative, spot foreign exchange is always required for physical delivery of the currency. A long foreign currency spot transaction is the direct purchase of one currency for another at the current market price. A short foreign currency spot transaction is the direct sale of one currency for another at the current market price.
Start Date – Start date refers to the beginning of the predetermined transaction period, where an underlying foreign currency position and/or foreign currency derivative is forecasted, recognized, or entered into. Strike Rate – Strike rate refers to the exchange rate at which an option permits its owner to buy or sell the underlying currency at maturity, which may refer to a vanilla option strike rate or a collar put or call strike rate.
T-Accounts – Accounting t-accounts are used to record transactions using double entry accounting, which implies that transactions are always recorded using two sides, debit and credit. Accounting t-accounts keep a record of accounting transactions in chronological order as they occur. T-accounts derive their name from the fact that they look like a letter "T", so it is called a T-account. Debit refers to the left-hand side and credit refers to the right-hand side of the T-account. A T-account is a convenient form to analyze accounts, because it shows both debit and credit sides of the account. T-accounts are commonly used to summarize transaction effects and determine balances for each general ledger account.
Total Hedge Value or Delta – The total hedge value or delta is the net value at the end of the predetermined transaction period of the combined foreign currency hedged item and foreign currency hedge instrument in a hedging relationship, a speculative foreign currency derivative position, or an exposed un-hedged underlying foreign exchange position.
Underlying – Underlying refers to the non-derivative foreign currency position. The ten most common underlying foreign exchange transactions are as follows; 1) forecasted unrecognized FX revenue, 2) forecasted unrecognized FX asset, 3) forecasted unrecognized FX expense, 4) forecasted unrecognized FX liability, 5) recognized FX receivable revalued through earnings, 6) recognized FX payable revalued through earnings, 7) long net income from a foreign currency functional subsidiary, 8) short net income from a foreign currency functional subsidiary, 9) long net investment in a foreign currency functional subsidiary revalued through equity, and 10) short net investment in a foreign currency functional subsidiary revalued through equity.
Unfavorable (Disadvantageous or Unacceptable) – Please see favorable definition above.
Unrecognized Foreign Currency Position – An unrecognized FX position, or an un-booked FX position, means that the FX risk is contained inside the transaction in the form of a later recognized higher or lower functional currency value, and in turn, a variance in gross margin, operating income or cash flows depending on the nature of the FX position. Unrecognized FX risk exists from the time that an exposure is forecasted to when the exposure is actually recorded on the balance sheet, and is not subject to mark to market accounting with gains and losses recognized on a current basis like a recognized FX position noted above. For example, foreign currency revenue is an unrecognized FX position, and unlike a recognized FX position, changes in the value of the forecasted revenue are not recorded on the income statement. Instead, the economic impact is felt upon booking the forecasted revenue in the form of higher or lower functional currency revenue. Please see term Forecasted Transaction.
U.S. Generally Accepted Accounting Principles (GAAP) – U.S. GAAP refers to the authoritative accounting guidance established by the Financial Accounting Standards Board (FASB), which is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public's interest. US GAAP sets forth rules and guidance related to specific underlying foreign exchange positions, generic derivative instruments, and default and elective accounting references for hedging activities among other areas of financial reporting guidance.
Value – The term value refers to the functional currency price that would be received to sell a foreign currency asset or paid to transfer a foreign currency liability in an orderly transaction between foreign exchange market participants at the measurement date, which may be the start, interim or end date of the predetermined transaction period.
Volatility – FX volatility refers to the volatility of the FX rate for the currency pair. FX volatility is the annualized percentage change in a foreign exchange rate in terms of standard deviation. FX volatility is an essential component in determining the value of a currency option. The three most common forms of FX volatility are (1) historical volatility, which refers to the actual volatility that occurred in the past, (2) future volatility, which is the forecasted volatility for the FX rate over a predetermined period, and (3) implied volatility, which is the volatility that reflects the present market price of an option determined by supply and demand in the option market.